Tuesday, January 25, 2011

Many argue that too much debt on the part of U.S. households was one of the contributing factors to the 2008-09 recession. Whether that's true or not, households have managed to deleverage impressively since late 2007. Total financial burdens (monthly payments on mortgages, consumer debt, auto leases, homeowner's insurance, and property tax, as a % of disposable income) dropped 11% in the three years ended last September, and mortgage and consumer debt burdens dropped by almost 15%. By these measures, financial burdens are now close to their average of the past 25 years.

Mortgage defaults undoubtedly have contributed to the deleveraging process, but so has a lot of refinancing of existing mortgages—many millions of households now enjoy paying the lowest mortgage interest rates in many generations. According to Merrill Lynch data, the average rate on all existing mortgages dropped by half a percentage point from Sep. '07 to 5.1% in Dec. '10. Regardless of how the deleveraging occurred, household finances on average are in much better shape today than they were three years ago.

I also note that deleveraging has proceeded at a fairly rapid pace even as the economy has been recovering. This underscores the point I've made repeatedly that leverage does not create growth—it merely transfers demand from one person (the lender) to another (the borrower).

6 comments:

Hi Scott, I have been a big fan of yours on Seeking Alpha for years and now follow your blog. I disagree with some of your political conclusions but your level-headed interpretation of the economic data (especially in the face of your many critics) has been right on.

I don't understand your last statement about demand being the same with or without leverage. $1M in the bank is not creating any demand for goods or services, but that same $1M (or $2M or more due to our fractional banking system) loaned out to business or consumers creates lots of purchasing power that helps the economy.

Re demand and leverage: Borrowed money can come from two sources: from another person or business, or from a bank. If it comes from another person, then it should be clear that no new demand is created when person A lends money to person B. Person A had to earn the money somehow, and instead of spending it himself he lends it to B who spends it. If it comes from a bank, and the bank creates the money using bank reserves held at the Fed, then it is "new" money. That new money can create what appears to be new demand when it is spent. But take that to it an extreme and you see that it is not really new demand. Supposed banks gave everyone a million dollar loan with money created out of thin air. The economy wouldn't grow at all, you would just see a huge amount of inflation.

The key to understanding what is going on is this: very little of the money that is used for "leverage" comes from banks; almost all comes from other people or entities. If banks were creating all the leverage, then we would have seen a huge increase in the money supply, but we haven't. Money supply has grown about 6% per year for decades. The Fed's job is to see that banks are lending too much.

Actually, according to Milton Friedman, if we create new money and there is slack in the economy, the new money will in fact create economic growth, and not inflation. When the economy reaches capacity, new money creates inflation, according to doctrine.

Milton Friedman, along with Bernanke and John Taylor, all advised Japan to deploy QE in the 1990s and mid-2000s. All said it would result in growth first in Japan, and then inflation.

Japan tried QE in the middle part of the decade, and Taylor gushed about the results, pronouncing it a success.

Bernnake is applying the QE lesson the the USA. Taylor says it is not a good fit for the USA now (Friedman has passed on, so we have lost his interpretation of current events). But it is Bernanke who is calling the shots, and so far the results appear wonderful. We are in fact getting grwoth with minimal inflation.

With so much slack in the current economy, I figure if you wave a $100 at someone, they will work for it, not raise their prices.

In addition, the USA runs open borders. That means when demand increases in the USA, labor, capital, goods and services pour in here, tamping down wages and costs.

I wonder if Bernanke will be able to obtain the 2 percent annual inflation the Fed targets. We are a long way from there. Some say we are actualy in deflation now, as the CPI overstates inflation.